FE Editorial : Year of bad money

SummaryThis year has seen a major upheaval in global finance. It will prompt a rethinking of many traditional views about how finance can be made to work well. In 2008, we have once again learned the critical importance of deposit insurance.

This year has seen a major upheaval in global finance. It will prompt a rethinking of many traditional views about how finance can be made to work well. In 2008, we have once again learned the critical importance of deposit insurance. The job of deposit insurance is to ride forth into the battlefield when things are going bad and find the wounded soldiers. Banks have to be laid to rest before they become insolvent, before they can induce trouble for the rest of the economy. The hero of the crisis was the US FDIC, which was the quiet overseer of the death of more than a dozen banks in such fashion through 2008. In the UK, weaknesses of deposit insurance were one factor which led to the Northern Rock crisis. The UK is now likely to build a US FDIC-style structure to cope with failing banks. As the Rajan committee has emphasised, India also urgently needs fundamental reform of the DICGC, which is (at present) merely a department of RBI that pays out money to depositors when a bank goes bust. Deposit insurance premia are also likely to go up significantly worldwide, reflecting this renewed awareness of the vulnerability of banks. More generally, there are now renewed concerns about the difficulties of banking. Banks give assured returns with full liquidity to depositors and put the money into opaque and illiquid assets, with very high leverage. As an example, the leverage of PSU banks in India is 20 to 1, while the leverage with index futures trading at NSE is 6 to 1. This combination of five difficult factors—high leverage, opaque assets, illiquid assets, assured returns to depositors and full liquidity to depositors—is a daunting one. For this reason, banking has been a disaster-prone industry for centuries. Hence, there is a case for public policy to exert subtle levers of influence and bias the country in favour of a securities market-dominated financial system rather than one in which banks are an important part.

Turning to securities markets, the major lesson of 2008 is the vulnerability of OTC contracting, where counterparties talk to each other on the phone or on a chat system, where the transparency of an exchange is absent and where there is counterparty credit risk. When Bear Stearns approached death, the US Fed was forced to help JP Morgan buy the firm owing to the repercussions in the OTC market